Anti-Gap Fade Tactics

Dec 22, 2007: 12:17 PM CST

We have been discussing various gap-fade tactics, and Thursday I mentioned that it’s best not to fade a gap in the Dow Jones index greater than 100 points and the market must have heard us talking about it! I didn’t know the Market read my blog!

In all seriousness, there is no technique that works 100% of the time, but for me the “Gap-Fade” tactic has been working extremely well over the last few weeks and months.

The premise is the following:

Fade any gap that occurs that is less than 100 Dow points. Play initially for the gap close.

When the gap is closed, play (trade) in the direction of the gap with a target of the gap open.

If the first trade is stopped out (depending on your risk tolerance) then flip your position and trade in the opposite direction for a ‘trend trade’ with an unspecified larger target.

Another caveat is that if a gap occurs that is greater than 100 Dow points, trade pullbacks in the direction of the gap for a larger target, and establish a ‘trend’ or core position early on and watch for breaks of key moving averages.

Let’s see what this action looked like on Friday’s intraday DIA chart:

This is the “Gap and Run” style trade where the market is just too strong to fade (sell-off) an initial momentum and price impulse. You want to get your trade on early and hold for a large (unspecified) target and sell when price clearly breaks a key moving average (be it the 20 or 50, depending on your risk tolerance).

This core trade would have allowed entry around $133.60 or so with exit either at the close or when price broke the 20 convincingly (which actually didn’t happen even at the close).

This trade would have been worth just under $1.00 and could have been leveraged by similar patterns in other stocks (with higher volatility) or the futures market (as I do).

Whatever the reason, be it “short covering” or not, the gap pattern was the same.

Not only is it best NOT to fade gaps that are greater than 100 Dow points (or $1.00 on the DIA), but it’s best to trade in the direction of those gaps when they occur.

If 70% to 80% of gaps fill immediately, then it’s best to analyze the minority percentage that do not when they occur to see if there are exploitable edges or strategies that take advantage of this relatively rare condition.

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